July 18, 2016

What’s Moving the Market’s Views on the Path of Short-Term Rates?

As today's previous macroblog post highlighted, it seems that the United Kingdom's vote to leave the European Union—commonly known as the Brexit—got the attention of business decision makers and made their business outlook more uncertain.

How might this uncertainty be weighing on financial market assessments of the future path for Fed policy? Several recent articles have opined, often citing the CME Group's popular FedWatch tool, that the Brexit vote increased the probability that the Federal Open Market Committee (FOMC) might reverse course and lower its target for the fed funds rate. For instance, the Wall Street Journal reported on June 28 that fed funds futures contracts implied a 15 percent probability that rates would increase 25 basis points and an 8 percent probability of a 25 basis point decrease by December's meeting. Prior to the Brexit vote, the probabilities of a 25 basis point increase and decrease by December's meeting were roughly 50 percent and 0 percent, respectively.

One limitation of using fed funds futures to assess market participant views is that this method is restricted to calculating the probability of a rate change by a fixed number of basis points. But what if we want to consider a broader set of possibilities for FOMC rate decisions? We could look at options on fed funds futures contracts to infer these probabilities. However, since the financial crisis their availability has been quite limited. Instead, we use options on Eurodollar futures contracts.

Eurodollars are deposits denominated in U.S. dollars but held in foreign banks or in the foreign branches of U.S. banks. The rate on these deposits is the (U.S. dollar) London Interbank Offered Rate (LIBOR). Because Eurodollar deposits are regulated similarly to fed funds and can be used to meet reserve requirements, financial institutions often view Eurodollars as close substitutes for fed funds. Although a number of factors can drive a wedge between otherwise identical fed funds and Eurodollar transactions, arbitrage and competitive forces tend to keep these differences relatively small.

However, using options on Eurodollar futures is not without its own challenges. Three-month Eurodollar futures can be thought of as the sum of an average three-month expected overnight rate (the item of specific interest) plus a term premium. Each possible target range for fed funds is associated with its own average expected overnight rate, and there may be some slippage between these two. Additionally, although we can use swaps market data to estimate the expected term premium, uncertainty around this expectation can blur the picture somewhat and make it difficult to identify specific target ranges, especially as we look farther out into the future.

Despite these challenges, we feel that options on Eurodollar futures can provide a complementary and more detailed view on market expectations than is provided by fed funds futures data alone.

Our approach is to use the Eurodollar futures option data to construct an entire probability distribution of the market's assessment of future LIBOR rates. The details of our approach can be found here. Importantly, our approach does not assume that the distribution will have a typical bell shape. Using a flexible approach allows multiple peaks with different heights that can change dynamically in response to market news.

The results of this approach are illustrated in the following two charts for contracts expiring in September (left-hand chart) and December (right-hand chart) of this year for the day before and the day after Brexit. With these distributions in hand, we can calculate the implied probabilities of a rate change consistent with what you would get if you simply used fed funds futures. However, we think that specific features of the distributions help provide a richer story about how the market is processing incoming information.

Prior to the Brexit vote (depicted by the green curve), market participants were largely split in their assessment on a rate increase through September's FOMC meeting, as indicated by the two similarly sized modes, or peaks, of the distribution. Post-Brexit (depicted by the blue curve), most weight was given to no change, but with a non-negligible probability of a rate cut (the mode on the left between 0 and 25 basis points). For December's FOMC meeting, market participants shifted their views away from the likelihood of one additional increase in the fed funds target toward the possibility that the FOMC leaves rates where they are currently.

The market turmoil immediately following the vote subsided somewhat over the subsequent days. The next two charts indicate that by July 7, market participants seem to have backed away from the assessment that a rate cut may occur this year, evidenced by the disappearance of the mode between 0 and 25 basis points (show by the green curve). And following the release of the June jobs report from the U.S. Bureau of Labor Statistics on July 8, market participants increased their assessment of the likelihood of a rate hike by year end, though not by much (see the blue curve). However, the labor report was, by itself, not enough to shift the market view that the fed funds target is unlikely to change over the near future.

One other feature of our approach is that comparing the heights of the modes across contracts allows us to assess the market's relative certainty of particular outcomes. For instance, though the market continues to put the highest weight on "no move" for both September and December, we can see that the market is much less certain regarding what will happen by December relative to September.

The greater range of possible rates for December suggests that there is still considerable market uncertainty about the path of rates six months out and farther. And, as we saw with the labor report release, incoming data can move these distributions around as market participants assess the impact on future FOMC deliberations.

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Lockhart Casts a Line into the Murky Waters of Uncertainty

Is uncertainty weighing down business investment? This recent article makes the case.

Uncertainty as an obstacle to business decision making and perhaps even a "propagation mechanism" for business cycles is an idea that that has been generating a lot of support in economic research in recent years. Our friend Nick Bloom has a nice summary of that work here.

The minutes of the June FOMC [Federal Open Market Committee] meeting clearly pointed to uncertainty about employment momentum and the outcome of the vote in Britain as factors in the Committee's decision to keep policy unchanged. I supported that decision and gave weight to those two uncertainties in my thinking.

At the same time, I viewed both the implications of the June jobs report and the outcome of the Brexit vote as uncertainties with some resolution over a short time horizon. We've seen, now, that the vote outcome may be followed by a long tail of uncertainty of quite a different character.

But he followed that with something of a caution…

If uncertainty is a real causative factor in economic slowdowns, it needs to be better understood. Policymaking would be aided by better measurement tools. For example, it would help me as a policymaker if we had a firmer grip on the various channels through which uncertainty affects decision-making of economic actors.

I have been thinking about the different kinds of uncertainty we face. Often we policymakers grapple with uncertainty associated with discrete events. The passage of the event to a great extent resolves the uncertainty. The outcome of the Brexit referendum would be known by June 24. The interpretation of the May employment report would come clear, or clearer, with the arrival of the June employment report on July 8. I would contrast these examples of short-term, self-resolving uncertainty with long-term, persistent, chronic uncertainty such as that brought on by the Brexit referendum outcome.

As President Lockhart indicated in his speech, the Federal Reserve Bank of Atlanta conducts business surveys that attempt to measure the uncertainties that businesses face. From July 4 through July 8, we had a survey in the field with a question on how the Brexit referendum was influencing business decisions.

We asked firms to indicate how the outcome of the Brexit vote affected their sales growth outlook. Respondents could select a range of sentiments from "much more certain" to "much more uncertain."

Responses came from 244 firms representing a broad range of sectors and firm sizes, with roughly one-third indicating their sales growth outlook was "somewhat" or "much" more uncertain as a result of the vote (see the chart). Those noting heightened uncertainty were not concentrated in any one sector or firm-size category but represented a rather diverse group.

As President Lockhart noted in his speech, "[w]e had a spirited internal discussion of whether one-third is a big number or not-so-big." Ultimately, we decided that uncovering how these firms planned to act in light of their elevated uncertainty was the important focus.

In an open-ended, follow-up question, we then asked those whose sales growth outlook was more uncertain how their plans might change. We found that the most prevalent changes in planning were a reduction in capital spending and hiring. Many firms mentioned these two topics in tandem, as this rather succinct quote illustrates: "Slower hiring and lower capital spending." Our survey data, then, provide some support for the idea that uncertainties associated with Brexit were, in fact, weighing on firm investment and labor decisions.

Elevated measures of financial market and economic policy uncertainty immediately after the Brexit vote have abated somewhat over subsequent days. Once the "waters clear," as our boss would say, perhaps this will be the case for firms as well.

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January 31, 2014

A Brief Interview with Sergio Rebelo on the Euro-Area Economy

Last month, we at the Atlanta Fed had the great pleasure of hosting Sergio Rebelo for a couple of days. While he was here, we asked Sergio to share his thoughts on a wide range of current economic topics. Here is a snippet of a Q&A we had with him about the state of the euro-area economy:

Sergio, what would you say was the genesis of the problems the euro area has faced in recent years?

The contours of the euro area’s problems are fairly well known. The advent of the euro gave peripheral countries—Ireland, Spain, Portugal, and Greece—the ability to borrow at rates that were similar to Germany's. This convergence of borrowing costs was encouraged through regulation that allowed banks to treat all euro-area sovereign bonds as risk free.

The capital inflows into the peripheral countries were not, for the most part, directed to the tradable sector. Instead, they financed increases in private consumption, large housing booms in Ireland and Spain, and increases in government spending in Greece and Portugal. The credit-driven economic boom led to a rise in labor costs and a loss of competitiveness in the tradable sector.

Was there a connection between the financial crisis in the United States and the sovereign debt crisis in the euro area?

Simply put, after Lehman Brothers went bankrupt, we had a sudden stop of capital flows into the periphery, similar to that experienced in the past by many Latin American countries. The periphery boom quickly turned into a bust.

What do you see as the role for euro area monetary policy in that context?

It seems clear that more expansionary monetary policy would have been helpful. First, it would have reduced real labor costs in the peripheral countries. In those countries, the presence of high unemployment rates moderates nominal wage increases, so higher inflation would have reduced real wages. Second, inflation would have reduced the real value of the debts of governments, banks, households, and firms. There might have been some loss of credibility on the part of the ECB [European Central Bank], resulting in a small inflation premium on euro bonds for some time. But this potential cost would have been worth paying in return for the benefits.

And did this happen?

In my view, the ECB did not follow a sufficiently expansionary monetary policy. In fact, the euro-area inflation rate has been consistently below 2 percent and the euro is relatively strong when compared to a purchasing-power-parity benchmark. The euro area turned to contractionary fiscal policy as a panacea. There are good theoretical reasons to believe that—when the interest rate remains constant that so the central bank does not cushion the fall in government spending—the multiplier effect of government spending cuts can be very large. See, for example, Gauti Eggertsson and Michael Woodford, “The Zero Interest-rate Bound and Optimal Monetary Policy,” and Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, "When Is the Government Spending Multiplier Large?”

Theory aside, the results of the austerity policies implemented in the euro area are clear. All of the countries that underwent this treatment are now much less solvent than in the beginning of the adjustment programs managed by the European Commission, the International Monetary Fund, and the ECB.

Bank stress testing has become a cornerstone of macroprudential financial oversight. Do you think they helped stabilize the situation in the euro area during the height of the crisis in 2010 and 2011?

No. Quite the opposite. I think the euro-area problems were compounded by the weak stress tests conducted by the European Banking Association in 2011. Almost no banks failed, and almost no capital was raised. Banks largely increased their capital-to-asset ratios by reducing assets, which resulted in a credit crunch that added to the woes of the peripheral countries.

But we’re past the worst now, right? Is the outlook for the euro-area economy improving?

After hitting the bottom, a very modest recovery is under way in Europe. But the risk that a Japanese-style malaise will afflict Europe is very real. One useful step on the horizon is the creation of a banking union. This measure could potentially alleviate the severe credit crunch afflicting the periphery countries.

Thanks, Sergio, for this pretty sobering assessment.

By John Robertson, a vice president and senior economist in the Atlanta Fed’s research department

Editor’s note: Sergio Rebelo is the Tokai Bank Distinguished Professor of International Finance at Northwestern University’s Kellogg School of Management. He is a fellow of the Econometric Society, the National Bureau of Economic Research, and the Center for Economic Policy Research.

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November 04, 2010

Some in Europe lag behind

Since around June, news of European fiscal deficits, financial markets stresses, potential sovereign debt defaults, or even a breakup of the euro zone has faded. The focal points of global economic policy have shifted to the sluggish recovery in developed countries and potential for further unconventional monetary stimulus.

A cursory look at a few key data reflects an improved European economic outlook from this summer. The simple dollar/euro exchange rate (see chart 1) shows that since June 1 the euro has appreciated nearly 15 percent against the dollar. While many different factors affect exchange rates—and increasing expectation of further monetary stimulus in the United States has helped the euro appreciate against the dollar—some of the appreciation seems to reasonably reflect the relative improvement of market sentiment about the fiscal situation in several European countries. Similarly, looking at the major stock indexes (mostly in Western European nations) shows a steady improvement from the lows of this summer, with the Euro Stoxx 50 index rising nearly 11 percent since June 1 (see chart 2). Thus, looking at most aggregate European data paints a picture of relative improvement, though most forecasters expect sluggish growth going forward. It's when one examines individual countries that it becomes clear some are lagging behind.

While the early stages of the European sovereign debt crisis centered on the fiscal scenario in Greece, market stress eventually spread to all the so-called PIIGS (Portugal, Ireland, Italy, Greece, and Spain) and even appeared to threaten the wider euro zone. Following an assortment of unprecedented interventions—highlighted by the 750 billion euro (approximately $1.05 trillion) rescue package from the European Union (through the European Financial Stability Facility) and support from the International Monetary Fund—market confidence slowly grew, and since this summer, various measures of financial market functioning have stabilized.

But while the threat of wider European contagion appears contained, fragilities remain. As has been documented in a variety of media reports, the recent improvement masks the individual euro zone peripheral countries' struggles with implementing fiscal consolidation, improving labor competiveness, resolving fragile banking systems, and staving off a crisis of confidence in sovereign debt markets.

Both bond spreads of individual European sovereign debt (over German sovereign debt) and credit default swap spreads show some stabilization for a few of the euro zone countries, but spreads in three countries—Greece, Ireland, and Portugal—are distinctly more elevated than the others (see charts 3 and 4).

The reasons for rising financing costs in these countries vary. In Ireland, for example, concerns about the Irish banking system (and the resolution of Anglo Irish Bank, in particular) were initially the driving cause. In Portugal, it was doubt over the implementation of necessary economic reforms that drove investor reluctance to provide financing; the recent adoption of austerity measures into the 2011 budget should alleviate some worry. But now much of the market action in both Irish and Portuguese bonds is focused on tough new bailout rules being implemented by the European Union.

On one hand, the renewed financing pressure brought upon these countries is less worrisome because of the backstop of the European Financial Stabilization Facility (EFSF). In fact, Moody's thinks it is unlikely there will be a euro zone default. Should market financing become too expensive for Greece, Ireland, or Portugal, the special purpose vehicle (SPV) imbedded within the EFSF could help by providing financing up to 440 billion euros ($616 billion).

But on the other hand, as part of the wider crisis prevention following the introduction of the EFSF, most European governments are implementing some level of fiscal austerity measures. From a political perspective, the implementation of these austerity measures varies widely, as demonstrated recently by the strikes in France over legislation trying to raise the retirement age. In addition to the uncertainty of implementing fiscal consolidation, there is pressure from the administrators of the EFSF to enforce burden-sharing on private bondholders in the event of any future bailout. This pressure is the primary impetus causing investors to shun the weaker peripheral countries.

One important player in this saga is the European Central Bank, which began buying European bonds for Greece, Ireland, and Portugal (among others) in conjunction with the EFSF announcement. Yet in recent weeks this bond buying has abated, and with money market pressures remaining in Europe, "something clearly has to give way," as Free Exchange wrote recently.

The problem is there are simply way too many folks in China, Europe, and the UNITED STATES engaged in 'finance.' Having 'solved' the agricultural problem with the green revolution in the 1960s ( mass produced el cheapo fertilizer for all ) all these folks moved off the farm and went to work at the local bank/hedge fund/gambling hall ... and what they have designed is the perfect 'world financial casino' that is destined to blow itself up.

No two countries are exactly the same so by giving up their monetary policy independence to form the ECB these countries have lost the ability to steer their economies at will, each country has different macroeconomies and trying to solve them all with the same "pill" isn't working for countries which clearly have varying debt-GDP ratios.
There is a saying that a person is only as rich as the people around him or her and that is the case with the European Union where the booming economies have tax payers funding the struggling economies and by allowing the interbank rates to rise, the ECB is showing it's inability to sustain different economies at the same time. Increasing interest rates only end up reducing outputs in low debt-GDP Euro countries and having the opposite effect in high debt-GDP ones, it'll be a case of you win some, you lose some. The onus is left to the stronger economies, France and Germany, to keep supporting the struggling economies till those economies pick up

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June 30, 2010

Keeping an eye on Europe

In June, a third of the economists in the Blue Chip panel of economic forecasters indicated that they had lowered their growth forecast over the next 18 months as a consequence of Europe's debt crisis. When pushed a little further, 31 percent said that weaker exports would be the channel through which this problem would hinder growth, while 69 percent thought that "tighter financial conditions" would be the channel through which debt problems in Europe could hit U.S. shores.

Tighter financial conditions also were mentioned by the Federal Open Market Committee in its last statement, where the committee noted, "Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad."

In his speech today, Atlanta Fed President Dennis Lockhart identified the European sovereign debt crisis as one of the sources of uncertainty for the U.S. economy that he believes "have clouded the outlook." President Lockhart explicitly expressed his concern that Europe's "continuing and possibly escalating financial market pressures will be transmitted through interconnected banking and capital markets to our economy."

Negative effects from the European sovereign debt crisis can be transmitted to the U.S. economy through a number of financial channels, including higher risk premiums on private securities, a considerable rise in uncertainty, and sharply increased risk aversion. Another important channel is the direct exposure of the U.S. banking sector—both through holdings of troubled European assets and counterparty exposure to European banks, which not only have a substantial exposure to the debt-laden European countries but have also been facing higher funding costs. The LIBOR-OIS spread has widened notably (see the chart below), liquidity is now concentrated in tenors of one week and shorter, and the market has become notably tiered.

Banks in the most affected countries (Greece, Portugal, Ireland, Spain, and Italy) and other European banks perceived as having a sizeable exposure to those countries have to pay higher rates and borrow at shorter tenors. Although for now U.S. banks can raise funds more cheaply than many European financial institutions, some analysts believe that there's a risk that the short-term offshore dollar market may become increasingly strained, leading to funding shortages and, conceivably, forced asset sales.

Bank for International Settlements data through the end of December of last year show that the U.S. banking system's risk exposure to the most vulnerable EU countries appears to be manageable. U.S. banks' on-balance sheet financial claims vis-á-vis those countries, adjusted for guarantees and collateral, look substantial in absolute terms but are rather small relative to the size of U.S. banks' total financial assets (see the chart below). The exposure to Spain is the biggest, closely followed by Ireland and Italy. Overall, the five countries account for less than 2 percent of U.S. banks' assets.

U.S. exposure to developed Europe as a whole, however, is much higher at $1.2 trillion, so U.S. financial institutions may feel some pain if the European economy slows down markedly. How likely is a marked slowdown? It's difficult to determine, of course, but when asked about the largest risks facing the U.S. economy over the next year, the Blue Chip forecasters put "spillover effects of Europe's debt crisis" at the top of their list.

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September 01, 2009

Us and them: Reviewing central bank actions in the financial crisis

With all the focus on the financial crisis in the United States, folks in this country might sometimes lose sight of the fact that this crisis has been global in nature. To provide some perspective on the global dimensions of the crisis, we are providing a few summary indicators of financial sector performance and central bank policy responses in the United States, the United Kingdom, the Euro Area, and Canada. Based on this general review, we surmise that some of the experiences have been remarkably similar, while others appear to be quite different. To pre-empt the question: Why these four regions? The reason is simply that the data were readily available. We encourage readers to use data from other areas, and let us know what you find.

The first chart compares relative changes in monthly stock market price indices for 2005 through the end of August. During the crisis, market participants significantly reduced their exposure to risky assets, which helped push equities lower. All indices peaked in 2007, except Canada, which technically peaked in May 2008. Canada outperformed relative to the others in early 2008 but suffered proportionally similar losses thereafter. The United Kingdom, Euro Area, and Canada bottomed in February 2009 while the United States bottomed in March 2009. The Euro Area to date has experienced the strongest rebound in equities, increasing by almost 40 percent since the trough in February. However, Europe also had the largest peak-to-trough decline, almost 60 percent. Canada and the United States have jumped by about 33 percent since their respective lows in February and March, while U.K. stock prices have risen by about 30 percent since February.

The second chart compares long-term government yields. As the crisis unfolded in late 2007, yields on 10-year U.S. Treasuries sank as global flight to quality helped push yields lower. Yields on U.S., U.K., and Canadian bonds have all moved lower than they were prior to the onset of the crisis. Interestingly, in the Euro Area, prior to the crisis, sovereign yields were at or below bond yields in the other countries but are now slightly above those. In fact, Euro Area yields haven't moved much since the beginning of the crisis in late 2007.

The third chart contrasts monetary policy rates in the four regions. The chart shows that all the central banks lowered rates aggressively, but there are some subtle differences in the timing. For the United Kingdom, Euro Area, and Canada, the bulk of policy rate cuts came after the financial market turmoil accelerated in the fall of 2008, whereas in the United States the majority of the cuts came earlier.

The Fed was the first to lower rates, cutting the fed funds rate by 50 basis points in September 2007 at the onset of the crisis. The Fed continued to lower rates pretty aggressively through April 2008, with a cumulative reduction of 325 basis points. Once the financial turmoil accelerated again in the fall of 2008 the Fed cut rates again by another 200 basis points.

The Bank of Canada's cuts followed a generally similar timing pattern to the Fed but with differences in the relative magnitude of the cuts. In particular, the Bank of Canada rate lowered rates by 150 basis points through April 2008 and then by another 275 basis points since September 2008.

Similarly, the Bank of England cut rates three times in late 2007/early 2008, totaling 75 basis points. But like the Bank of Canada, the bulk of their policy rate cuts didn't come until the increased financial turmoil in the fall of 2008. Between September 2008 and March 2009, the Bank of England cut the policy rate by 450 basis points.

Unlike the other central banks, the European Central Bank (ECB) did not initially adjust policy rates down as the crisis emerged in late 2007. In fact, after holding rates steady for several months it increased its rate from 4 percent to 4.25 percent in July 2008. It started cutting rates in October 2008, and from October 2008 to May 2009 the ECB reduced its refinancing rate by 325 basis points. Of the four regions, the ECB currently has the highest policy rate at 1 percent. For some speculation about the future of monetary policy rates for a broader set of countries, see this recent article from The Economist.

The final chart compares relative changes in the size of balance sheets across the four central banks. The balance sheet changes might be viewed as an indication of the relative aggressiveness of nonstandard policy actions by the central banks, noting that some of the increases can be attributed to quantitative easing monetary policy actions, some to central bank lender-of-last-resort functions, and some to targeted asset purchases.

The sharpest increases in the central bank balance sheets came in the wake of the most intense part of the financial crisis, in the fall of 2008. There had been relatively little balance sheet expansion until the fall 2008. Prior to that, the action was focused mostly on changing the composition of the asset side of the balance sheet rather than increasing its size. The size of both U.S. and U.K. balance sheets has more than doubled since before September 2008, although both are now below their peaks from late 2008. Note that in the case of the Bank of England, quantitative easing didn't begin until March 2009, and the subsequent run-up in the size of the balance sheet is much more significant than in the United States. Prior to that, the increase in the Bank of England balance sheet was associated with (sterilized) expansion of its lending facilities.

In contrast, the Bank of Canada and ECB increased their balance sheets by about 50 percent—much less than in the United Kingdom or United States. By this metric, nonstandard policy actions have been less aggressive in Canada and the Euro Area. Why these differences? This recent Reuters article provides a hypothesis that focuses on institutional differences between the Bank of England and the ECB. In a related piece, this IMF article compares the ECB and the Bank of England nonstandard policy actions.

Note: The Bank of England introduced reforms to its money market operations in May 2006, which changed the way it reports the bank's balance sheet data (see BOE note).

By John Robertson, vice president and senior economist, and Mike Hammill and Courtney Nosal, both economic policy analysts, at the Atlanta Fed

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Re : "Of the four regions, the ECB currently has the highest policy rate at 1 percent."

Please, this is the kind of "analysis" we all could do without. You are comparing apples and pears. If you want to compare the US policy rate, i.e. an interbank overnight rate target, to something relevant in the Eurozone, then pick a euro overnight rate. Eonia has been at around 0.35% since June, not 1%, which is currently used as the very long term tender rate. As to 1 month Euribor, it is currently 0.48% while 1 month USD Libor is 0.28%.

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March 20, 2009

A look at the Bank of England’s balance sheet

The current financial crisis is global in scope, with central banks responding in various ways to mitigate the strains in their respective countries. The Federal Reserve is not the only central bank that has been aggressive in its response. For instance, the Bank of England's (BoE) Monetary Policy Committee, in its March 5 policy statement, explained the details of its new asset purchase program:

"…the Committee agreed that the Bank should, in the first instance, finance £75 billion of asset purchases by the issuance of central bank reserves. The Committee recognised that it might take up to three months to carry out this programme of purchases. Part of that sum would finance the Bank of England's programme of private sector asset purchases through the Asset Purchase Facility, intended to improve the functioning of corporate credit markets. But in order to meet the Committee's objective of total purchases of £75 billion, the Bank would also buy medium- and long-maturity conventional gilts in the secondary market. It is likely that the majority of the overall purchases by value over the next three months will be of gilts."

Thus, the BoE will purchase £75 billion of assets (approximately U.S. $108 billion as March 20 and U.S. $106 billion as of March 5), mostly intermediate-to-longer dated U.K. sovereign debt (or gilts) but also some "investment grade" corporate bonds. Along with this new asset purchase program, to ease strains in credit markets the BoE has previously implemented other efforts, such as purchasing commercial paper, asset-backed securities, and corporate bonds. But these earlier efforts were conducted in such a way that the BoE sterilized its purchases—that is, for every £1 of private assets it purchased, the BoE would issue £1 of its own debt (sterling bills), with the effect being that the money base (bank reserves plus currency in circulation) grew much less than the overall size of the balance sheet.

However, with the new asset purchase program, the BoE is targeting a quantity of U.K. sovereign debt to purchase in an unsterilized manner, hence the key phrase "by the issuance of central bank reserves." As stated, the BoE will be buying gilts, "with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target [2% CPI inflation] in the medium term."

As the size of the asset side of the BoE's balance sheet grew, so did the liability-side:

Notice that much of the increase in the liabilities has come from "other liabilities" and "short-term open market operations" and not "reserve balances." But with the new asset purchase program, reserve balances will become much larger.

By Laurel Graefe and Andrew Flowers, economic analysts at the Atlanta Fed.

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It never occurred to me that quantitative easing, if successful, could be sterilized.

The entire point of quantitative easing is to put assets into the economy that increase the money supply - whether through expanding the quantity of money, or increasing the velocity of money. The former BoE actions did not increase the quantity of currency notes - as said, for ever pound sterling that comprised asset purchases, a pound of sterling was taken out of the economy. They should, however, have increased the velocity of money, by ridding the system of systemic risk. Whether the BoE achieved this is certainly controversial, but doubtless it was their intent in this massive purchase. So, if quantitative easing did occur, then it could not have been sterilized - i.e., the money supply expanded.

Alternatively, sterilization could remain a useful term if defined as an expansion of the money supply strictly through efforts to increase velocity, rather than through the more common route of increasing the quantity of money.

As a tangential thought, it's possible that the BoE's 'sterilization' policy actually contracted the money supply, if the routes through which they took in pound sterling had a higher propensity to spend than the routes through which they issued sterling (i.e. the banking sector). As all the banks are currently holding on to money like Scrooge McDuck, I wouldn't be surprised it this was the case. Perhaps that explains their current policy transformation to unsterilized asset purchases, which face no propensity to spend tradeoff.

Assuming a contraction of credit is near permanent (reserve requirements / a generation of bankers realise risk exists), then maybe the need to sterilise is eliminated. And voila, not only has HMG had its deficit funded, but when its banking assets are sold it will make a profit. We maybe a lot better off than we thought.

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June 12, 2007

Putting The Money Back In Monetary Policy?

With euro-zone interest rates near a six-year high, European Central Bank policy makers are clashing over the role of the swollen supply of money in pushing up prices.

That rare break in the bank's public facade of unity suggests policy makers are divided about how high to push interest rates in the 13-nation currency bloc, and it could rekindle a global debate on the merits of monitoring money supply...

Years of low interest rates have fueled a global liquidity glut that has inflation-wary central bankers world-wide paying attention to money-supply data. The ECB, as the only major central bank to give money-supply growth an official role in its decision-making, has led the charge. But other policy makers, including at the Bank of England and Sweden's Riksbank, have also cited strong money-supply growth as a reason for recent interest-rate rises.

... we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output.

... We assume that the central bank checks regularly whether a filtered money growth series adjusted for output and velocity trends averages around the inflation target. If the central bank obtains successive signals of a sustained deviation of inflation from target it adjusts interest rates accordingly.

Our simulations indicate that persistent policy misperceptions regarding potential output induce a policy bias that translates into persistent deviations of inflation and money growth from target. In this case, our “two-pillar” policy rule may effectively overturn the policy bias. Cross-checking relies on filtered series of actual money and output growth without requiring estimates of potential output. Indirectly, however, it helps the central bank to learn the proper level of interest rates.

This paper addresses the relative importance of monetary indicators for forecasting inflation in the euro area. The analysis is carried out in a Bayesian framework that explicitly considers model uncertainty with potentially many explanatory variables...

The empirical results show that money is an integral part of the forecasting model... The key finding of the paper is is that the majority of models include both monetary and non-monetary indicators.

To paraphrase, when it comes to short-run forecasts, the kitchen sink works best. But the result that got my attention was Scharnagl and Schumacher's finding that, in their experiments, the trend in the money supply is the only factor that appears useful in forecasting inflation once you get out beyond about 6 quarters.

That may surprise you, but it probably shouldn't. The Scharnagl and Schumacher study is on the technical side, but some years ago economists George McCandless and Warren Weber offered up some evidence which was pretty easy to grasp:

That's a graph of the relationship between average money growth (measured by M2) and average inflation for a large cross-section of countries, over the period from 1960 through 1990. If you are an old hand on this topic, you probably remember that it was around 1990 that both the ECB and the Federal Reserve lost confidence in the money measures they were tracking. The ECB responded by moving from a narrow measure of money to the very broad M3 concept. The Federal Reserve responded by more-or-less abandoning monetary measures all together.

OK, let's take a look at the McCandless and Weber picture post-1990:

Hmm. The Wall Street Journal article correctly notes that there is still a great deal of skepticism about the usefulness of monetary measures in formulating monetary policy:

The U.S. Federal Reserve is among the doubters. Fed Chairman Ben Bernanke said in November that a "heavy reliance" on money-supply data as a predictor of U.S. inflation was "unwise."

I don't think either the Beck-Wieland or Scharnagl-Schumacher work contradicts that skepticism about "heavy reliance." But maybe money deserves just a little more love on this side of the Atlantic than it currently gets?

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Francesco Giavazzi argues that monetary policy in Europe could be greatly improved with increased transparency at the European Central Bank: Sarkozy and the ECB: Right intuition, wrong target, by Francesco Giavazzi, VoxEU: During his electoral campaign... [Read More]

Tracked on Jun 18, 2007 4:27:30 PM

Comments

And, maybe credit is more important than money, in the sense of the increasing ease with which economic actors can find credit which is less and less under the "control" of even the influence of the Fed.

For example, when vendors offer 0% interest out of desperation to get business, how effective is modest tweaking of the money supply?

Or, when "investment" flows into the domestic economy from outside the U.S. and the attraction is the rate of return of the investment irregardless of the level of "general" interest rates that the Fed might seek to influence.

Even banks have access to far more "capital" than the "money" they might borrow at the federal funds target interest rate, right?

And with securitization, banks don't even need much capital to sustain a "lending" business, right?

Mostly we simply accumulate "money" in money market mutual funds where it earns relatively high interest rates and effectively "grows" even more money (M2) much faster than the economy's need for capital in the form of "money", right?

We need to radically rethink our conceptions of "money" relative to "capital" and the needs of the economy for each.

MxV=PxQ. Problem is that central banks only look at P for goods and services, if they included P of assets then the mystery is solved. What makes this period different from others since 1960 is that Chinda 'beavers' have built a dam that prevents M flowing into price inflation the stream being diverted into asset inflation, which according to CB's isn't inflation at all. Heaven help when the dam gives way (protectionist/ USD depreciation/ excess foreign domestic demand).

Thanks for the reference! Here is a relevant quote from the paper Jef found:

"Our second finding is that this strong link between inflation and money
growth is almost wholly due to the presence of high-inflation or hyperinflation
countries in the sample. The relation between inflation and
money growth for low-inflation countries (on average less than 10% per
year over 30 years) is weak, if not absent."

First, there is no ambiguity in forecasts. In contradistinction to Bernanke, forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The FOMC, etc., has learned their catechisms;
Friedman became famous using only half the equation, leaving his believers with the labor of Sisyphus.
The lags for monetary flows (MVt), i.e., real GDP and the deflator are exact, unvarying, constant. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).
Not surprisingly, adjusted member commercial bank free legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –-- their lengths are identical. The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly. Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets (housing being most notable), it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The "administered" prices would not be the "asked" prices were they not “validated” by (MVt).

Milton was loath to grant central bankers much discretion in formulating and executing monetary policy.

(1) Friedman couldn't define/kept changing the definition of the "money" supply to target. Money is the measure of liquidity, the "yardstick" by which the liquidity of all other assets is measured.
(2) the "monetary base/high powered money” [sic] is not a base for the expansion of the money supply.
(3) the "multiplier" is derived from "money" divided by member commercial bank legal reserves, not the monetary base..
(4) aggregate demand is measured by monetary flows (MVt), i.e., income velocity is a contrived figure (WSJ, Sept. 1, 1983)
(5) the rates of change used by the Fed are specious (always at an annualized rate having no nexus with economic lags; Friedman pontificated variable lags; economic lags are unvarying)
(6)Friedman (1959) has long advocated the payment of interest on reserves at a market rate in order to eliminate the distortions associated with the tax on reserves.

A. Friedman didn't know the difference between the supply of money and the supply of loan funds.
B. didn't know the difference between means-of-payment money and liquid assets.
C. didn't know the difference between financial intermediaries and money creating institutions.
D. didn't recognize aggregate monetary demand is measured by the monetary flows (MVt) not nominal GDP.
And the technicians at the Fed:
E. don’t recognize that interest rates are the price of loan-funds, not the price of money
F. don't recognize that the price of money is represented by the price (CPI) level.
G. don't realize that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds.
That's some legacy.

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May 26, 2007

Why Not Just Ask?

I'm home at last from the Conference on Price Measurement for Monetary Policy that has absorbed my attention over the past couple of days, but I have one more post on the topic left in me, not least because the topic of the last several papers -- the measurement of inflation expectations gleaned from survey data -- is one in which I have a particular interest. As far as I know, the review of the ECB Survey Professional Forecasters (SPF) (by authors from the European Central Bank too numerous to mention here) is the first large-scale overview of its kind, and thorough it is. Among the copious information is this, which I found particularly interesting:

... average long-term expected inflation has remained quite stable since the beginning of the survey. On average, it stood at 1.88% with a standard deviation of ±0.04 percentage point. The average long-term inflation expectation was 1.9% at the start of Stage III of EMU in 1999. It declined to 1.8% in 2000 and then shifted upwards to stand at 1.9% again at the end of 2002. Since then, it has remained broadly stable at below, but close to, 2%, confirming the stability of SPF long-term inflation expectations.

While there is clearly no doubt about the accuracy of official inflation measures in the euro area during the recent period, there is plenty of anecdotic evidence that since 2002 consumers have tended to perceive that inflation is high, while in reality it was relatively low, albeit slightly above the quantified definition of price stability for the euro area. Apparently a perception gap has grown in the euro area since the euro cash changeover in January 2002.

The pictures are striking:

The kicker is that no such divergence in perceptions occurred in comparable European countries that did not adopt the euro:

I'm not sure what to make of that, other than that there is an awful lot we don't know about what consumers are telling us when they answer these survey questions -- an observation that is confirmed in a review of survey responses from the Czech Republic, Hungary, Poland, and Slovakia by Ryszard Kokoszczynski, Tomasz Lyziak, and Ewa Stanislawska (of the National Bank of Poland).

Until we more clearly understand household responses to the questions we ask, it appears that surveys of professional forecasters represent the best available source for obtaining direct information about inflation expectations. There is growing literature on how to get the most out of these surveys, and I'll close with a word of praise for the paper "What Can Four Decades of Probabilistic Inflation Forecasts Tell Us About Inflation Risks?" by the ECB's Juan Angel Garcia and Andres Manzanares. As the title of the paper makes clear, the idea is to characterize, for example, whether survey respondents see the balance of inflation risks as weighted to the upside or downside. The literature to which the Garcia-Manzanares paper belongs tends to the technical, but it is well worth a look if you have a stake in knowing which way the forecaster winds are blowing.

I participated to the SPF from the start in 1999 (including commenting on the design) and stopped a couple years ago as I am now based 4 degrees north...

In my experience, the fact that you note, eg the stability of long term expectations simply reflects that forecasters are not well equipped to make forecasts 5 or 10 years out. Therefore most of us would reply in the 1.8-1.9 range to that particular question as a reflection of our understanding that the particulars of the ECB mandate made inflation control its overriding objective and that we thought that it had at its disposal the understanding of the inflationary process and the tools to make sure that it achieved this objective. Any deviation from these figures would reflect a severe loss of credibility of the ECB.

On the deviation between the public's perception (up) and the measured reality of inflation, many of us noted this early on. This reflected the fact that prices for those items that the public purchases at high frequency using coins and notes (the value of which they had some trouble assessing early on) rose steeply in the first few years. However, because these expenditures are but a small part of consumer's budgets, it did not affect notably overall prices. Other items purchased at low frequency (ex. cars, rents,insurance,clothes etc.) did not see such price movements.

Three points remain very interesting here in my view:

1. the fact that consumer's perceptions distort the weights of high frequency purchased items using hard cash compared to others (let us call in psychologists and economists for research). Politicians were quick to seize on this in some Euro member countries.

2. checks and plastic money do not impress consumer memories the way coins and notes do.

3. Even wrongly but actually held inflationary views could have important consequences in the wage-price negotiating area. It took the ECB a long time to acknowledge this risk. In other words, is it actual price movements or perceived price movements that matter for wage setting ?

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"I want an integrated Europe, in other words, a Europe that has borders ... Turkey is in Asia Minor."

... and immigration control is front and center:

"Who can't see that there's a clear link between the uncontrolled immigration of 30 or 40 years and the social explosion on our housing estates?"

The immigration issue is a complicated one, and I have no business commenting a sovereign nation's assessment of how to best deal with the social consequences of open borders. But this story, from the Wall Street Journal (page A2 in the print edition), provides an interesting juxtaposition:

The quality of life for some 80 million graying baby boomers in the U.S. may depend in large part on the fortunes of another high-profile demographic group: millions of mostly Hispanic immigrants and their children.

With a major part of the nation's population entering its retirement years and birth rates falling domestically, the shortfall in the work force will be filled by immigrants and their offspring, experts say. How that group fares economically in the years ahead could have a big impact on everything from the kind of medical services baby boomers receive to the prices they can get for their homes.

The article does not make a French connection, but one is not hard to conjure up. A few years back, a Rand Corporation study had this to say:

The history of French population change is atypical; secular fertility decline began one century before the rest of the West. As a consequence, France had the oldest population in the world over the entire period of 1850–1950. The baby boom after the Second World War created a temporary increase in the number of births, but thereafter the fertility decline resumed. With current below-replacement fertility and increased life expectancy, population ageing is expected to reach new heights...

Family policies in France are a complicated mix, as the Rand article makes clear, and recent efforts at promoting fertility among native French citizens appear to have met with some success. But this bottom line judgment, from the UN, remains relevant:

In most developed countries, the decline in fertility and the increase in longevity has raised three concerns for the future: the decrease in the supply of labor, the socioeconomic implications of population aging, and the long term prospect of population decline and demise...

On the medium run, the next ten years or so, the labor market is the main focus of concern. The reference system comprises here the set of supply and demand variables that determine the employment equilibrium. The impact of fertility and mortality changes is for that purpose at this time horizon very limited. Conversely, international migration could play a decisive role, as well as other socioeconomic variables.

For the long run, - from 2020 to the population projections horizon 2040-2050- structural imbalances of the age distributions are things to worry about.

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